An Introduction to the Keynesian Model
Clearly something needed to be done as the economy continued its slide into Depression. By 1932, GDP decline had averaged 10 percent per year, unemployment was approaching one-quarter of the labor force, international trade was down by two-thirds, stocks had lost 80 percent of their value, and about forty percent of the nation's banks had closed. As we saw earlier, there are strong ties between economic theory and economic policy and the prevailing Classical model severely constrained public policy makers. If we were to see any substantial shifts in macroeconomic policy, we would first need to see a shift in the prevailing economic theory. Economic policies are grounded in economic theory, and until the Classical model could be successfully challenged, the guidelines for policy officials would be maintenance of the gold standard and a balanced budget.
The theoretical base for a reconsideration of macroeconomic policy was provided by John Maynard Keynes in his 1936 book, The General Theory. Crowding - out, the centerpiece of the Classical view was to be replaced by the multiplier, the central concept in the Keynesian view. The dynamics of the Keynesian multiplier are captured in historian Gerald Johnson's description of the impact of the panic in 1929, of how this shock wave rippled through the economy.
"When the panic of 1929 suddenly wiped out the whole value of many stocks and sharply reduced the values of others, a great number of people who had thought themselves rich, or at least well-off, found themselves with much less than they had thought they had, or with nothing at all. By [the] millions they quit buying anything except what they had to save to stay alive. This drop in spending threw the stores into trouble, and they quit ordering [new products] and discharged clerks. When orders stopped the factories shut down, and factory workers had no jobs"
Keynes' ideas were simple and based on the premise that the prevailing Classical theory, while maybe adequate as a guide to what would happen in the long run, was not particularly valuable to policy makers who could not afford to operate in that time frame. Keynes said as much when he suggested that "In the long run we are all dead." To Keynes it was "obvious that the appropriate assumptions vary greatly according to circumstances," and that the circumstances of the Great Depression demanded a reassessment of the assumptions upon which the Classical model rested. Where Classical economists had focused all of their attention on aggregate supply, Keynes focused his attention on aggregate demand. Where Classical economists had focused on flexible prices, Keynes focused on potential rigidities in prices.
In the labor market, Keynes felt that workers were unemployed and machinery lay idle because there were simply no customers looking for the products that could be produced. Where Classical economists indicated that wages would adjust downward and return the economy to full employment, Keynes questioned the flexibility of wages as adequate to provide clearance of the labor market, and suggested that wages could get "stuck" above the market clearing wage with unemployment resulting.
The good news was, when underemployed resources existed, an expansion in employment could take place without any upward pressure on wages and prices. Keynes' logic was quite simple. If a potential buyer were to go to a company with an order for more 'stuff,' the company would be able to find the needed workers among the pool of unemployed workers, possibly workers that had been recently laid off by the company. Once these workers were added to the payrolls they would be able to produce more 'stuff' without any upward pressure on wage rates. As Keynes saw it, the existence of massive numbers of unemployed eliminated workers' bargaining power.
The situation can be described in the graph below. The initial labor market equilibrium is at the intersection of the labor supply and labor demand curves. Employment would be E1 and the wage rate would be W1. Once the economy slows and demand for labor decreases, the Classical model would say that wages would fall and reestablish an equilibrium at a lower wage rate. Keynes, meanwhile, suggested that wages would be inflexible downwards so they would "get stuck" at the existing wage rate. Employment would fall to E2, but there would still be E1 people willing to work at that wage rate. The gap between E1 and E2 would be the level of unemployment.
Diagram 1K
Keynesian Labor Market
Keynes also questioned the assumptions of flexible interest rates and suggested that interest rates could get stuck at non-market clearing rates. In difficult times, the demand for investment funds might dry up. Excess capacity reduced businesses' projections of revenue so any cost savings due to lower interest rates would be inadequate to turn the value of the investment positive. Under these circumstances, there would be no increase in the level of investment spending as interest rates came down. In the diagram below, the decrease in demand that creates excess capacity drives down investment demand (I0 to I1). At this new level of investment demand there is no positive interest rate that will produce positive levels of investment. In this situation flexible interest rates would not create a balance between supply and demand for loanable funds. In a depressed situation there is nothing to suggest that the interest rate will be able to fall enough to recreate balance so there would be excess funds available if there was a growth in demand for funds. As Keynes saw things, if you were a business person that had just laid off 25 percent of your workers and you were running your machines at only 50 percent of capacity, it is unlikely that you will see a drop in interest rates as a signal to buy new machinery or build a new factory.
Diagram 2K
Savings-Investment Balance
When Keynes turned his attention to the output market, he focused on consumption spending. Ask yourself the question - what is the primary determinant of the level of spending that you do in a given year? I suspect that you will find income high on your list, and interest rates low on the list. An important point overlooked in the Classical view is that income is the primary determinant of spending by households - if people had more income they would buy more goods and services. Keynes recognized this and the relationship between income and consumption spending became a key piece of the complete macro model. The concept that Keynes introduced to capture the link between income and consumption is the marginal propensity to consume (MPC), defined as the change in consumption created by an increase in income. A marginal propensity to consume of .8, for example, means that for every $100 increase in income, consumption spending increases by $80.
Keynes also questioned the traditional view of money and showed that monetary policy could theoretically, but not empirically, affect the real economy. At this time, however, we will postpone this discussion until the 1970s. As we will see in that section, the lack of constancy in the "velocity of circulation of money" severed the Quantity Theory of Money's link between the money supply and aggregate output and thus ended the neutrality of money.
The logic of Keynes' analysis is presented in traditional texts either graphically or algebraically. While we will also look at the mathematical version of the model, our attention here will be focused on developing an understanding of the multiplier process by following the spending trail created by an increase in spending on public works financed by borrowing. Although we can begin the story anywhere, we will begin in the capital market where the government must come to borrow money to pay for the defense purchase.
When the government enters the capital market to borrow money, it finds the banks have an ample supply of cash. Because of the depressed state of the economy, businesses, which are the banks' traditional customers for loans, are reluctant to borrow money for plant and equipment investments due to the existence of excess capacity. They cannot sell what they can produce now with existing capacity so they do not need to borrow money to build newer factories. Because of this lack of private sector demand for investment funds, bankers will readily lend money to finance the increase in government spending without any upward pressure on interest rates. Interest rates will not rise when the government borrows the money and as a result there should be no crowding-out of private sector demand. The increase in G will not be offset by equivalent declines in I and C as suggested in the Classical model, and thus an increase in G increases aggregate demand and shifts the AD curve to the right.
To produce the additional output demanded by the government, businesses will need to recall workers. In the Classical world, the increased demand for workers would drive up the price of workers (wage rate), but at a time where the pool of unemployed workers is large, the businesses could rehire workers without any upward pressure of wages, and thus there would be no upward pressure on prices.
Continuing on with the money trail, once these workers are hired and receive their paychecks, they will attempt to buy goods and services with their new income. In Keynes' terminology, the "primary expenditure" on the roads, generated "primary employment" in road building. This in turn generated "secondary employment" in the production of goods and services so that the final change in expenditures / employment would be some multiple of the initial expenditure.
Does the additional demand force prices higher, or does it create additional output? According to Keynes, the increased consumption spending - purchases of homes, cars, food, clothing... will translate into increased production of those goods and services. As we saw earlier, his reasoning is straightforward - there are many businesses with idle factories and workers, and when the government comes looking for additional output, the firm simply recalls some workers and opens up some of the unused factory. There will be little upward pressure on wages due to the existence of unemployed workers who will be readily available to work at current wage rates.
The money trail has now led us through the labor and capital markets where we found increased spending produced no upward pressure on either interest rates, wages, or prices which would crowd-out private sector spending. This situation, where output can expand without any upward pressure on these prices, is represented in the AS-AD diagram below. In the Keynesian situation the AS curve is horizontal, not vertical as it was in the Classical model. The reason is workers will work for the same wage and firms will sell their "stuff" at the same prices and there will be an increase in output with no increase in prices.
Not surprisingly, this has a dramatic effect on the macro policy prescriptions. Just as the Classical model focused on the supply-side of the economy, Keynesian's focused on the demand side. If the economy was stuck in a recession and the government wanted to increase output to bring more people back to work, then the government would simply need to figure a way to increase aggregate demand (shit the AD curve outward).
Diagram 3
The Keynesian AS - AD Model
The Policies
The policy implications of the Keynesian model should be obvious - any successful efforts to increase AD will result in higher levels of output. More importantly, any initial increase in aggregate demand will eventually be transformed by the multiplier process into some multiple expansion in aggregate demand. We would show this with an outward shift in the AD curve. The change in the policy stance in the US was anything but smooth and continuous, however, as President Franklin D. Roosevelt vacillated on economic policy. In May of 1932, Roosevelt was promoting an activist position: "The country needs and, unless I mistake its temper, the country demands, bold, persistent experimentation." Within two months the pendulum swung back with Roosevelt promoting a balanced budget: "Government, like any family, can for a year spend a little more than it earns. But you and I know that a continuance of that habit means the poorhouse."
Keynesian policies were not fully accepted until the 1960s, but Keynes' solution to the unemployment problem was in keeping with the spirit of Roosevelt's New Deal. If the private sector could not be relied upon to provide adequate demand, then the government could step in as the "demander of last resort" and borrow funds to purchase goods and services. Rather than crowding-out the private sector, we have the multiplier effect of increased government spending that primes the economic pump. The magnitude of the final employment effect depends upon the share of the additional income that is spent on local production - the marginal propensity to consume. The formula for the multiplier DY/DG is:
DY/DG = 1/(1-MPC)
DY change in income
DG change in government spending
MPC = marginal propensity to consume
If, for example, individuals could be expected to spend 80 percent of any income on locally produced goods and services (MPC = .8), then a $100M increase in government spending would generate a final change in aggregate output / income of $500M [500/100= 1/(1-.8)].
Better still, these programs would not break the bank. As Keynes saw it, if by raising the level of government spending we could get people "off the dole" and back working, there was a good chance of improving the financial position of the state. Similarly, attempts to raise taxes would be counterproductive since it may be true that "taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction in taxation will run a better chance than an increase of balancing the budget"- a concept we will revisit when we look into Reaganomics in our discussion of the 1980s.
Diagram 4 outlines the Keynesian position on discretionary fiscal policy. Expansionary fiscal policy ( G ) would, by definition increase aggregate demand ( AD ). If we assume that the increased demand is accommodated by increased supply, then income will rise ( Y ) which will increase consumption spending ( C). But the second round increase in consumption will now set off a third round of expansion since this increase in aggregate demand will lead to a further increase in output. This increase in income may put upward pressure on interest rates, but this is expected to be quite small given the existence of surplus funds. Furthermore, if business conditions are bad when the policy is undertaken, the increase in income may actually increase investment demand - a crowding-in phenomenon. The result is that the initial increase in spending / or tax cut will produce a multiplied effect on output.
Diagram 4
Fiscal Policy in the Keynesian Model
The rest, as they say, is history. In the 1930s, Franklin D. Roosevelt pushed through a wide array of programs called the New Deal. In the 1940s, WW II provided the aggregate demand shock that lifted the economy out of the Depression. What remained to be seen was whether this anti-depression policy would catch on and whether it could be used as an anti-recession policy. This was a policy debate that was still a few decades off, although in the post WW II era the Keynesians quickly took the high ground in the academic debates. Before we go there, you may want to look briefly at the mathematical version of the Keynesian model that is a feature of most introductory economics books.